Dean Mouscher's masteroptions.com

According to my favorite indicator, there has been a huge shift in market sentiment over the last few days from worried to complacent, bearish to bullish.

As every market pro knows, one of the most important market indicators is sentiment.  Paradoxically, when the herd is most bullish, that’s when the market is most likely to fall.

But how best to know how bullish or bearish the herd is really feeling?

For me, the best way is to compare the action in the VIX to the action in the S&P 500 (the SPX).  That simple indicator can speak volumes.

It works like this.  What the VIX really tells you is how cheap or expensive SPX options are. When you buy an option, you are in every sense buying an insurance policy. So in its heart of hearts, the VIX represents the cost of crash insurance.

If the VIX is high, people are nervous about a crash and hesitant to sell insurance.  When the VIX is low, people are complacent.  They think selling options  is easy money.

To refine it a little more, if the VIX drops sharply every time the SPX goes up slightly – but rises only sluggishly when the market is down – that’s a sign of complacency, or bullishness.  It means option sellers are confident the market won’t crash, so they’re falling all over each other to sell premium.

But if the VIX rallies nervously in response to each minimal market decline – but barely drops when the market rallies – that means option traders are nervous about a crash, and scared to sell options.

Up until now, option traders have been very nervous premium sellers.  Even when the market was up strongly, the VIX dropped minimally.  And when the market dropped slightly, the VIX surged.

That has changed.  For one thing, as of today the VIX has closed lower an astounding 11 of the past 12 days.  Today – the twelfth day of that amazing run – the SPX was down.  Yet STILL the VIX fell!

In a nutshell, I would much rather be short the market here than long.  That doesn’t mean the market can’t go up for the next few days or even weeks.  But caution is definitely in order.

I’ve commented before on the nearly perfect inverse relationship between the S&P 500 and the VIX. When the SPX goes up the VIX goes down, and vice-versa.

A few people have written to say that actually it’s not all that uncommon for both the SPX and VIX to close up for the day, or for both to close down for the day.

Well, we’re both right. It turns out a lot depends on your time frame.

Below is a chart of the SPX and VIX, with each bar representing one minute. This is how I like to look at it. The almost-perfect inverse relationship is unmistakable.

Figure 1

And yet, look closer and you’ll see that on 9-3 both the SPX and the VIX closed DOWN for the day! I could say “As always, the inverse SPX/VIX relationship held almost to perfection.” And you could say “No, they both closed down.” And we’d both be right.

Far more interesting is when once in a blue moon – actually, far more rarely – you have a day such as last Wednesday July 15 (Figure 2 below). Not only was the SPX/VIX close-to-close relationship positive (they both closed up), but much more importantly, that correlation was just plain positive the whole day:

Figure 2

I wasn’t the only one struck by the SPX/VIX action that day – Bill Luby of http://vixandmore.blogspot.com/ wrote:

“The intraday tick for tick positive correlation between the VIX and the SPX was as strong as I have ever seen. Most of the time the VIX and the SPX move in opposite directions. Today it was almost as if someone has inverted the gravitational forces acting upon these two indices.”

What does it mean? In response to a comment, I wrote the following on July 16:

“So my best guess is that yesterday’s VIX anomaly represents skepticism that the stock market rise is for real, which is quite bullish.”

In other words, my take on it is that that day the SPX rose steadily to close almost 27 points higher. But the more it rose, the more SPX option traders refused to believe the rise could last, so the more they bought portfolio insurance in the form of SPX options, driving the VIX higher.

Rising bearishness in the face of rising prices is of course strongly bullish. And indeed, in the 7 trading days from July 15 to July 24, the S&P 500 cash index rose from 932 to 979.

Days such as July 15 – as charted in Figure 2 – occur so rarely they’re hard to study. But when you see the normal minute-by-minute inverse SPX/VIX relationship broken for an entire day, it seems clear to me that the market doesn’t buy that day’s trend. Meaning there’s a high probability it will continue for the immediate future.

Is it true that 90% of options expire worthless? If so, according to a popular argument, it proves that option sellers have the advantage over option buyers.

What a wonderful example of false logic. It leaves out the essential question, namely – how much do option sellers win on winning trades vs how much they lose on losing trades?

In other words, if you win a dollar 90% of the time – but lose $50 10% of the time, then you’re still a net loser.

The basic truth of being an option seller is well-known to every professional option trader. You will make money most of the time but get killed occasionally. And a one-time loss from a catastrophe can easily dwarf profits made over 10 years of steady markets.

I’ve seen it argued that you can make money selling options while hedging your risk. That’s like saying I can be paid for assuming risk yet actually take no risk. Doesn’t work. The myth of risk-free profits underlies such legendary blowouts as Long Term Capital, Bear Stearns, Lehman – the list goes on and on.

The truth is that no successful trader is either a 100% buyer of options or a 100% seller. The trick is to understand the market and do the right thing given current conditions. Sometimes that means being a buyer of options, sometimes a seller, sometimes a spreader. There’s no simple formula for success.